The complexities of inheriting an IRA
My Oak Partners practice is a useful source of inspiration for the column, serving such a wide variety of investors and families with unique planning needs. I figure if I am seeing an issue in the practice, chances are it is more and more common in the community as well.
One somewhat complex issue I have encountered a number of times lately is beneficiaries inheriting second generation beneficiary IRAs from individuals who themselves were the beneficiary of an original IRA. I know this sounds complicated, and it can be, so let's unpack it.
First, a primer. When an owner of an IRA or Roth IRA passes, the account value passes to the named beneficiaries on the IRA account. The process of receiving the IRA is independent of any will or living trust the decedent may have established -- when a beneficiary is named on an IRA (which is almost always), the account will pass completely separate from a will. What the IRA owner's will says simply doesn't matter.
When the beneficiary receives the account, the beneficiary has the option to transfer the account value to a special type of IRA known as a beneficiary IRA. This beneficiary IRA account is established in the name and social security number of the new IRA owner but will reference the name and date of birth of the original IRA owner as well. This new beneficiary IRA will require the new IRA owner to also name beneficiaries on the account, completely independent of the original IRA owner's named beneficiaries.
This new beneficiary IRA is subject to some specific IRS withdrawal rules. Please note, these rules only apply to a non-spouse, non-minor child or non-disabled beneficiary (called qualified beneficiaries). We will cover rules and strategies for a surviving spouse and other qualified beneficiaries in another column. These rules also only apply to IRA accounts inherited after January 1st, 2020 -- different rules apply for accounts inherited before this date.
The general rule for non-spouse, non-qualified beneficiaries is the IRA account must be completely distributed (and subject to tax if not a Roth IRA) by the end of the 10th year following the year of death of the IRA owner. The IRS does not specify how the IRA must be distributed by the end of the 10th year, simply that it must be fully distributed, except if the original IRA owner was age 73 or over and subject to Required Minimum Distributions (RMDs).
If the IRA owner had reached the age of Required Minimum Distributions, then the beneficiary inheriting the IRA account must continue the original IRA owner's RMDs during the 10-year period before full distribution. In my experience, in most situations, just continuing the RMD will not be sufficient to completely distribute the IRA in 10 years, so at some point IRA withdrawals must be accelerated. Which leads us to the inspiration for this column. What happens when the person who inherited the IRA passes away before the beneficiary IRA is fully distributed?
In this situation, the new named beneficiary of the beneficiary IRA, called the successor beneficiary, will open yet another beneficiary IRA, this time referencing the name of the successor beneficiary as well as the date of birth of both the original IRA owner and first beneficiary (hey, I don't make these rules up).
After the successor beneficiary IRA is established, the new IRA owner also inherits the distribution timeline of the original beneficiary. For example, if the original IRA owner was 75 and passed in 2021, the successor beneficiary IRA owner must continue the original IRA owner's RMD, but now only has until 2031 to distribute the entire account, consistent with the requirements of the first beneficiary to receive the IRA.
I know these rules can be confusing, but the tax penalty for not following them can be substantial. Anyone finding themselves in the situation of being a successor IRA beneficiary is highly encouraged to engage a qualified financial advisor and a qualified tax advisor to help navigate these rules -- and I am not going to consider the customer service rep answering the phones at an online investing firm as a qualified advisor. Sorry, but it's complex stuff. Please just get some local help.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stock investing includes risks, including fluctuating prices and loss of principal. No investment strategy can guarantee a profit or preserve against loss. Past performance is not a guarantee of future results. Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at marc.ruiz@oakpartners.com. Securities offered through LPL Financial, member FINRA/SIPC.
